Fait, Robert v. Hummel, Albert
333 F.3d 854 (2003)
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Rule of Law:
Under Illinois corporate law, the burden to prove the fairness of a transaction involving interested directors shifts from the board to the challenging shareholder if the transaction was approved by a majority of disinterested directors who possessed sufficient knowledge of all material facts concerning the company's financial condition and the proposed deal.
Facts:
- In 1998, Pentech Pharmaceuticals, Inc. issued Series A preferred shares, which granted investors a right of first refusal on new stock and the power to elect a majority of the board if Pentech violated certain covenants.
- In the fall of 2000, after a court found Pentech had violated the agreement, the Series A shareholders elected four of five directors, removing directors previously elected by common shareholders like Robert Fait.
- Robert Fait, along with Pentech's founder, owned more than two-thirds of the company's common stock.
- Pentech was in a dire financial situation, facing the possibility of bankruptcy.
- Discussions for a potential $20 million investment from another company, Julphar Pharmaceuticals, had broken down.
- On May 3, 2001, the Pentech board, with two disinterested directors voting in favor and one interested director abstaining, approved an offering of over 4.2 million shares of common stock at $1 per share.
- The stock offering diluted the voting power of existing common shareholders, including Fait.
- The Series A shareholders exercised their right of first refusal and purchased all the newly issued shares, securing their control over the company.
Procedural Posture:
- Robert Fait challenged the validity of a stock transaction in the U.S. District Court.
- The defendant board of directors filed a motion for summary judgment, which the district court denied.
- After a seven-day bench trial, the district court (the court of first instance) found in favor of the board.
- The district court concluded that Fait had the burden of proving the transaction was unfair and that he did not meet that burden.
- Fait (appellant) appealed the district court's ruling to the U.S. Court of Appeals for the Seventh Circuit.
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Issue:
Under Illinois law, does the burden of proving a transaction's fairness shift to the challenging shareholder when disinterested directors who approve the transaction have substantial business experience and general knowledge of the company's financial state and the deal's implications, but do not conduct independent expert research?
Opinions:
Majority - Judge Terence T. Evans
Yes, the burden of proving the transaction's fairness shifts to the challenging shareholder. Under 805 ILCS 5/8.60, approval by disinterested directors with knowledge of all material facts is sufficient to shift the burden of proof. The court found that the two disinterested directors, Myles and Ronsen, possessed the requisite knowledge. Myles had extensive experience in the pharmaceutical industry and had served on Pentech's board for years, reviewing its financial reports. Ronsen, as Pentech’s senior vice-president for seven years, was intimately familiar with the company's daily operations and financial history. Their first-hand knowledge of the company's dire financial state, the failed negotiations with Julphar, and the personal stakes of the interested directors was sufficient. The statute does not require disinterested directors to hire outside experts or conduct extensive independent research to be considered knowledgeable. Because the disinterested directors had sufficient knowledge, the burden shifted to Fait to prove the transaction was unfair, a burden he failed to meet.
Analysis:
This decision clarifies the 'knowledge of all material facts' standard within the safe harbor provision of Illinois corporate law for interested director transactions. It establishes that directors' business experience and long-term familiarity with a company's finances can satisfy the knowledge requirement, without mandating independent, third-party valuations or expert analysis. This lowers the threshold for boards to shift the burden of proof to a challenging shareholder, strengthening the deference given to board decisions under the business judgment rule. The ruling makes it more difficult for shareholders to challenge transactions approved by even a minority of disinterested directors, provided those directors are reasonably well-informed through their service to the company.
